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Venture capital and private equity (PE) firms are finding it increasingly difficult to raise money from their backers – limited partners (LPs) – who are becoming more demanding about the current models of return and the safety of their cash.

There are at least 40 fund managers or general partners (GPs) in the market trying to raise funds. While domestic LPs are a growing class of investors in the country, most of the money for fund managers comes from global entities. Any hesitancy on the part of LPs – the main source of capital for such investors – can lead to a disruption of the institutional investing system, not only in India but globally.

LPs, comprising mostly education and pension funds, are growing wary of giving away cash, particularly to first-time funds, as the internal rate of return (IRR) at most of them over the last 10 years has been largely negative.

The risk-averse asset class is coming up with new metrics to determine what constitutes a safe fund.

"Definitely, there is a hesitation from LPs in terms of who to back," said K Srinivasan, managing partner at BTS Investment Advisors.

"There has been an explicit increase in the due diligence process which has become stricter and more time-consuming."

The Mumbai-based firm, which manages two funds for small and medium enterprises, is currently raising a $120 million (Rs564 crore) clean technology fund.

The first point of debate is the 2/20 rule. In the PE investment world, this refers to a 2% management fee and a 20% outperformance fee. Investors typically pay 2% of committed capital to the management company to manage the fund and 20% of returned funds above the initial capital as an incentive.

Globally, LPs are trying to change the basic premise of the management fee. While the debate has been ongoing, it has become sharper in the last couple of years in the face of low returns. LPs have started examining the impact of high fees on returns and on team motivation levels. This is particularly true of fund managers who are on their second or third fund.

"We scrutinise the budget plans of GPs and try to instil discipline in the numbers, with the overall idea being to have a fee that is budgeted to the manager's needs and not necessarily to the 2% number," said Anubha Shrivastava, managing director at CDC Group, Asia, the UK government's development finance institution. "The idea is to let the GPs have sufficient capital to cover expenses but not deincentivise them via huge salaries."

What makes the management fee crucial is that it is utilised for paying salaries to the staff, office rents, electricity and other bills, including travel. However, it cuts through the IRRs of LPs, who are now trying to do away with expenditure hurting their bottom line.

"Returns are uncertain, but a reduction in fees leads straight to the bottom line," said Low Han Seng, executive director, investment management at Singapore-based United Overseas Bank Ltd, which backs PE firms in India.

"GP reaction depends on size of funds, historical performance (less argument if performance has been good) and investor profile (bigger ones are harder to ignore)."

Investors currently raising capital are feeling the heat.

"As budget is a reflection of various things, LPs are closely looking at the setting up fee of a fund, hurdle rates, contribution by GPs, among others.

Furthermore, if it is a big fund, the carry of 20% to GPs can also get compressed depending on the performance," said Sandeep Aneja, managing director of India's first education-focused fund Kaizen Management Advisors Pvt Ltd, which is raising a $150-200 million fund.

Raising money has become particularly difficult for first-time funds. Bangalore-based Stega Capital, for one, has realised that LPs are not keen on building new relationships in this market. Also, unlike earlier when they would commit to backing a fund, LPs are now asking for capital commitment from GPs to ensure hard work and loyalty by the managers.

"If it is an individual set of GPs founding a fund, LPs are seeking capital commitments of 5%. If it is an institutional fund, GPs are expected to contribute 10-20% of the fund size. They are insisting on partners as sponsors of the funds," said founder Srini Vudayagiri.

GPs usually charge the portfolio companies a fee for consultation, for being a board member, deal structuring fee and even an investment banker's fee if they get a strategic partner. LPs are now insisting that GPs cannot be paid twice by LPs and portfolio companies. LPs say these fees should come to them as a means of returning capital in smaller portions.

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